of highly effective investors

Last Modified: Saturday, December 22, 2012 at 5:20 p.m.

BACK IN 1989 ONE OF THE MOST popular business and self-help books of all time was published. Its title is, The Seven Habits of Highly Effective People.

One of the main theses of the book is that to be effective requires a change in mindset. In other words, people have to be prepared to change the way they look at things.

The same thing is true of investors. To be effective, they need to look at the fundamental concepts of investing in a way that may be quite different than their current way of thinking.

Any investor can have a good year or two, in line with the saying, even a stopped clock is right twice a day. But being a consistently successful investor requires more than luck. It requires a way of looking at investing that is superior to that of the crowd.

This pays off as the crowd significantly underperforms the market. According to the research firm Dalbar, over the last 20 years, the crowd generated a return of 3.49 percent, while the S&P 500 generated a return of 7.81 percent.

One of the most important habits of effective investors is to decide on their asset allocation — the division of their investment capital between equities, bonds and cash — before they make any investments. Studies show that this decision is the dominant factor that determines an investor’s returns. One study suggests that as much as 92 percent of an investor’s return can be explained by this one decision.

Effective investors avoid market timing; that is, jumping in and out of the market, trying to predict the market’s shorter-term direction.

Dalbar research shows the futility of this tactic. For example, in 2011 they report market timing equity investors lost 5.73 percent, while just holding the S&P 500 yielded a 2.11 percent gain.

Investors should also keep in mind that even professional investors haven’t been able to successfully market time consistently.

Effective investors think for themselves and don’t make a habit of following the crowd. This means that investors don’t hop on the bandwagon by buying the latest popular stock. Doing that usually results in poor results because, by the time a typical investor hears about such a stock, its price has already spiked and any easy money has been made.

Effective investors considering an investment ask first, How much money can I lose? not How much money can I make?

They also understand simple mathematics. If an investment they select goes down 50 percent, then to fully recover it has to go up not 50 percent but 100 percent.

Effective investors also know that minimizing costs is critical to long-term investing success, especially in a low-return environment.

For example, if over the next decade the market returns an annualized 7 percent gross return, then an equity portfolio of $100,000 that has costs of 2 percent will grow to about $162,889. One that has costs of only 1 percent will grow to about $179,085, a difference of $16,194.

This is one reason that many investors would be better served by low-cost passive-index mutual funds rather than higher-cost actively managed mutual funds.

Effective investors know risk and return are closely linked and that it’s critical to make sure any investment has a return that fully compensates for the risk.

For example, 10-year U.S. Treasury securities were recently paying about 1.7 percent.

The market is forecasting that inflation over the next 10 years will average an annualized 2.5 percent. Additionally, if interest rates rise, then not holding these to maturity will result in an actual loss of principal. For many investors, this analysis would imply the return is not worth the risk.

Effective investors also habitually factor their tax situation into their investment strategy.

Investors who ignore taxes will likely see lower after-tax portfolio returns.

This means that, at least under current law, investors need to hold the proper assets in their taxable and tax-deferred accounts.

For example, taxable bonds should be in a tax-deferred account and qualified dividend stocks in a taxable account.

Send comments and questions to Robert Stepleman, Business News, Herald-Tribune, 1741 Main St. Sarasota, FL 34236, or rsstepl@tampabay.rr.com